When processing payroll for yourself vs employees, choosing the right business structure is key to minimizing taxes. Determining how much and how often to pay helps with managing profitability and cash flow, which is why setting up a self employed payroll system is important. Good payroll services make it easy and support employers with tax law compliance.
If you need an easy way to automate payroll and file payroll taxes, consider using Gusto. You can use it to pay yourself as often as you’d like: weekly, biweekly, monthly, and so forth. The software can be set up within a few days, and you can pay yourself through direct deposit. Sign up for a free 30-day trial today.
Self Employed Payroll Providers
When choosing payroll software, employers must consider their business needs. Some services are simpler if you’re only paying yourself, while others offer more value if you’re paying additional workers. The business’ structure benefits you want to access, and available software integrations should all be considered when choosing a payroll provider. Although cost is also a top factor—for many, it’s No. 1—so it’s essential to analyze all the needs of a business before making a final decision.
Self Employed Payroll Services
LLCs with S-corp tax status that need to automate regular salary payments to owners
Nonprofit owners needing a cheap full-service payroll option that handles payroll taxes
Sole proprietorships that want to integrate payroll with existing QuickBooks accounting solutions
S-corp owners that want the business to subsidize their health insurance through payroll
Retail business owners needing to pay contractors in addition to themselves
How Payroll for Self Employed Owners Works
Payroll for self-employed business owners can work in multiple ways, but ultimately, the process still includes determining how to pay yourself and doing it. The primary concern is ensuring the way you compensate yourself is legal and cost-efficient.
Once you know how much to pay and how often to distribute payments, you’ll set up a fool-proof payroll system that involves pay calculations and a transfer of funds into your possession. There are different ways to process this transfer of funds, but determining the best way depends on your business type.
The most common business types are sole proprietorships (single owner), partnerships (multiple owners), limited liability companies (LLCs), S corporations (S-corp), and C corporations (C-corp). Some common differences are the way they raise money, number of owners, and taxes they pay. If you haven’t yet chosen your business type, you should review your options and make a decision prior to paying yourself.
Here’s a list of the most common business structures, their attributes, and the business types or industries they’re best for.:
- Sole proprietorship: A sole proprietorship is a business that has a single owner. It requires little to no paperwork, and all taxes are passed down to the owners’ personal tax return. There is no personal liability protection, so customers could sue the owner if issues arise.
- Best for: Photographers, writers, virtual assistants, bookkeepers, tutors, housekeepers, small consulting businesses, and new small businesses with limited customers
- Partnership: A partnership is a business that has more than two owners. There’s a partnership agreement that governs how the owners divide profits and losses, and all taxes are passed down to their personal tax returns.
- Best for: Family businesses like a father-son moving company, certified public accountant (CPA) firms, and law firms
- C-corp: A C-corp is usually a large business that issues stock to raise money and has a board of directors who governs company decisions. Owners are protected from personal liability, but it’s costly to get started and requires extensive paperwork. Earnings are double-taxed when absorbed by the C-corp and when distributed to owners. C-corps are separate entities and not for the self-employed.
- Best for: Large companies that need to raise capital to transition to the next business stage
- S-corp: An S-corp can range from a small to large business and provides protection from personal liability. Owners can have the business taxed as a sole proprietorship or partnership, and all profits are passed down to their personal tax returns.
- Best for: Consulting companies, businesses earning more than $40,000 in profits or enough that establishing an S corp would save money on taxes
- LLC: An LLC provides liability protection to owners in the event of a lawsuit.
- Best for: Small businesses that have at least a few steady clients
We advise you to speak with a tax professional before choosing or changing your business structure. There are numerous factors to consider aside from what we’ve listed, and every business situation is unique.
Payment Types Business Payroll
There are several ways to pay yourself, and although they may all seem the same to you, the IRS treats them differently at tax time. Depending on how your business is organized, you may be better off paying yourself an owner’s draw, a regular salary, dividend, distribution, guaranteed payment, or a mixture thereof. Before we dive into which payments are best for each legal entity and how to do payroll, it’s important that you understand the differences among the payment types.
Owner’s Draw vs Regular Salary
A draw is money taken out of a business for personal use by the owner—usually sole proprietors or single-member limited liability companies (LLCs)—that can’t be written off as a business expense. Unlike regular salary payments, a draw is not considered a payroll expense and isn’t subject to withholding taxes like Social Security and Medicare (FICA) or federal and state income taxes.
The only businesses that are eligible to take owners’ draws are sole proprietorships. Partnerships operate similarly, but because there are multiple owners, the withdrawals are called partnership distributions (distributive shares). The most important factor to remember about owners’ draws is that they don’t operate like salary payments, meaning they cannot be deducted as expenses to reduce taxable income.
Regular salary payments are for owners classifying themselves as employees, for instance with S-corps. If you opt for a regular salary, you must reduce your salary payout by any payroll deductions, like health insurance, and withholding taxes like FICA. Your business must then remit the withholdings along with employer payroll taxes on your wages to the appropriate tax agencies.
Guaranteed Payments vs Distributions
Guaranteed payments are set up by partnerships to ensure the owners receive a minimum amount of business income for the period, regardless of how much income the business reports. A partnership distribution is the allocation partners agree upon regarding how to split the company’s total profits and losses, for example―50% and 50%. S-corp owners can take distributions as well. A guaranteed payment is a specific dollar amount each partner must receive while partnership distributions are usually set percentages.
Guaranteed Payments and Distributions Example
Bill and Jennifer made an agreement that includes a 50/50 net profit divide for each year. This year, the business earned $30,000, which equates to $15,000 to each partner. This is a partnership distribution. The agreement also includes a $20,000 guaranteed payment for Jennifer, who brings years of experience to the business that Bill doesn’t. The business would pay out an additional $5,000 ($20,000 guaranteed – $15,000 distribution) to ensure the guaranteed payment is met for the period.
This guaranteed payment isn’t a salary, so payroll taxes aren’t withheld; however, the company can write it off as a business expense, reducing taxable income for the business. However, the owner who receives a guaranteed payment will be subject to self-employment taxes. On the contrary, a business cannot write off a partnership distribution, so taxable income will include all money paid to the owners; the owners will pay taxes on the gross profit.
Dividends vs Distributions as Self Employed Payroll Payments
Dividends are regular payments made to a C-corp’s shareholders out of profits the business earns. These payments are typically paid in cash, like distributions, but can also be distributed as additional shares of stock. They’re divided according to the total stock a shareholder owns in proportion to the total stock outstanding. If you own 25% of the available stock, you’ll receive 25% of declared dividends. In addition, the dividends are taxed.
One attribute owners enjoy about paying themselves in dividends is that they can typically be taxed at a lower rate than regular salary, potentially saving up to 20% in taxes. Partnerships and LLCs don’t pay any taxes on distributions, but the owners are subject to self-employment taxes when their share of the earnings pass down to their personal tax returns. S-corps can issue tax-free non-dividend distributions to owners as long as they don’t exceed their equity in the company.
It’s important to understand the basic payment types available for self-employed payroll processing. Often, business owners assume they can withdraw money from the business however they want only to be charged excessive penalties and taxes for not complying with applicable laws. We encourage you to do additional research in addition to consulting with a tax advisor before finalizing your new self-employed payroll processing system.
Here’s how to process payroll for the self-employed in six steps.
1. Choose Your Business Type
The primary payroll concern for many entrepreneurs is how much to pay themselves. However, before determining how much business income to distribute to yourself, it’s a good idea to spend time contemplating what’s best for the business.
Your business structure—sole proprietorship, partnership, corporation—should form the basis of all payroll decisions you make regarding how to pay yourself. You could save thousands of dollars in taxes and avoid IRS audits if you set your business up correctly. If you or your accountant have already completed the paperwork to determine your business structure, take time to learn the different options and responsibilities you have in regard to processing your own payroll.
Payment Types by Business Structure
|LLC (not elected as a corporation for tax purposes)|
With a sole proprietorship, you can pay yourself a draw as much and as often as you want. An owner’s draw doesn’t affect your taxes but merely reduces your capital investment in the company. The draws are however subject to a 15.3% self-employment tax along with business income taxes. Self-employment taxes are FICA and Medicare taxes for the self-employed—similar to FICA taxes that are paid half-and-half by the employee (7.65%) and the employer (7.65%).
In a partnership, each partner is only responsible for reporting their agreed-upon percentage or amount. There are no employee or employer taxes, but the earnings are subject to self-employment taxes.
Owners of a C-corp aren’t considered self-employed. It’s an entity that’s legally recognized as separate from its owners; business income is taxed at the corporate level and shareholder level once dividends are distributed. You can opt to pay yourself a salary, since business entities are allowed to have employees, or plan to take dividend payments as the board of directors approves.
With an S-corp, you can pay yourself in dividends and lower your tax rate. However, if you perform substantial work for the company, you should be classified as an employee of the S-corp. This will help you avoid the self-employment tax, but payroll taxes will be withheld from your paycheck.
Tip: If you will be providing substantial work to the company, it’s best to speak with a tax adviser before deciding whether or not to classify yourself as an employee. If you opt not to be an employee to avoid paying payroll taxes, the IRS can automatically reclassify you after an audit and subject you to back taxes and penalties.
Limited Liability Companies
Members of an LLC aren’t employees and don’t receive a salary. For tax purposes, LLCs with one owner are treated similar to sole proprietorships—owner’s draw—and multi member LLCs are treated like partnerships—distributions or guaranteed payments. However, you can opt to recognize an LLC as an S-corp or C-corp for tax purposes to have more beneficial payment options.
2. Determine How Much to Pay Yourself
Once you’ve evaluated the different business structures and how you can pay yourself with each, decide how much you’re worth to the business. If your business is a sole proprietorship or partnership, you can pay yourself any amount—$100 a month or $10,000 a month. If it’s an S-corp or C-corp, and you opt to classify yourself as an employee, the IRS requires your salary be “reasonable.”
In determining what a reasonable salary is, consider the market rate for the services you’re providing to the company. Check popular job sites for job posts, because they sometimes list pay rates or have salary comparison tools. Underpaying or misclassifying yourself as an employee or nonemployee can lead to an audit and additional taxes and fees.
In those cases that you have more autonomy in determining how much to pay yourself, keep in mind that the pay should still be reasonable to allow your business to continue growing. You should avoid paying out all of the income in case of emergencies. Consider how much your contributions are worth to the company, the type of work you’re performing, and the total profits coming into the business.
3. Set Your Pay Frequency
Typically, you can pay yourself as often as you’d like, but it’s a good idea to set a consistent pay frequency to keep the process organized. If you’re taking owner draws or distributions, you may want to pay yourself less often until you have enough experience with the flow of business income—seasonality can cause low cash flow during certain periods.
If you classify yourself as an employee of your business, you should pay yourself more often to align with the practices of other employers. Guaranteed payments for partnerships should be structured according to the original agreement between the partners—for instance, monthly minimum payments should be settled by the end of the month.
4. Set up a Payroll System
After determining how often to pay yourself, you’ll be ready to set up a payroll system to help with automation and compliance. You can use online payroll templates to give you access to automated calculations. Setting yourself up in the system shouldn’t require much time; you’ll enter your name, Social Security number, and so on. If you want direct deposit, you’ll submit bank account information.
If you choose to run payroll with software like Gusto, you can set your payroll to run on autopilot.
Gusto will run payroll for you automatically two days before your payroll deadline. If you decide to classify and pay yourself as an employee, Gusto will withhold and remit your employee and employer payroll taxes—without any required action from you. Visit the website for a free demo.
5. Enter and Review Hours Worked or Salaried Wages
Regardless of which payroll system you use, you’ll need to either track hours worked or salary due per period in addition to work performed. If you’re receiving payment as an employee, you should have a solid foundation on which to form your wage calculations.
Annual salaries are based on what the market is paying and how much work you do; divide the total salary by the number of pay cycles in the year to calculate how much you should receive each period.
An owner’s draw, distribution, and dividend payment don’t require as much justification as a salary payment. Neither does a guaranteed payment for a partnership, although you can deduct it from taxable business income. You’re not required to perform any valuable services on behalf of the business to be entitled to any of these funds; you can withdraw funds simply because you’re the owner. However, it’s still a good idea to enter and review all payment amounts prior to distributing to avoid paying the wrong amount.
6. Approve and Process Payroll
Once you’ve documented and reviewed what you’re planning to pay yourself, you can approve and process it using the tools available to you. Online payroll systems typically have a page that allows you to click approve or submit before funds are disbursed.
Keep in mind that gross pay should be the same as net pay for any non-salary payments pertaining to your self-employed payroll, meaning there won’t be any tax payments withheld. As for paying a salary, you should see the appropriate amounts withheld for self-employment taxes and benefits (like for a Solo 401k), if applicable.
Most payroll payments are made via check or direct deposit. If you’re not yet using payroll software, you can print payroll checks free online. All you need is a magnetic ink cartridge, printer, and payroll check stock. Of course, direct deposit is the most convenient option since money is deposited within your bank account within two to four business days. Pay cards are another option.
To reiterate, you should consult with a tax adviser before finalizing any major changes in how you will be processing your self-employed payroll. There are numerous tax consequences that can result, and it’s best to have a professional on hand to answer any questions you may have.
There are many factors to consider when doing payroll for self employed entrepreneurs—most importantly, business structure. You could easily end up paying more than a thousand dollars extra if you neglect to pay yourself a reasonable salary from an S-corp or forget to make quarterly payments to cover your sole proprietorship’s self-employment taxes.
If you’d like to try a payroll software service that will pay you with little to no effort from you on the back end, consider Gusto. Once you set up the amount you want to be paid and how often, Gusto will handle the rest. With the click of five buttons, you can set payroll to run on autopilot. Sign up for a free trial today.
Disclaimer: Fit Small Business does not operate as a licensed legal or tax professional. We recommend you consult with your lawyer, payroll accountant, or licensed professional for decisions related to your payroll process.